Summary 5 Measurement in the Macro-economy

RECAP

Macroeconomics is the branch of economics that examines the entire economy. In this case, macroeconomics will lead you into an investigation in the following issues;

1. Unemployment (Unit 7)

2. Inflation (Unit 6)

3. GDP Growth (Unit 5/U6)

4. International trade (Unit 4)

5. Balance of Payment and exchange rate issues (Unit 6)

PURPOSE OF PRESENTATION

This presentation provides a brief introduction to two important macroeconomic phenomenon i.e. unemployment and inflation.

UNEMPLOYMENT

TERMS RELATED TO UNEMPLOYMENT

1. Unemployment – all those people who are willing and able to work

but are unable to find jobs (Hardwick et al, 1994).

2. Unemployment Rate – (see below)

3. Participation Rate – Measures the labour force as a percentage of the

total population within the working age.

4. Discouraged Worker – A worker who withdraws from the labour

market because of poor job prospects

(Hardwick et al,1994)

5. Working Population – Employed plus the unemployed.

6. Labour Force – Those people in the economy who are willing and

able to work (within the working age).

7. Labour Productivity – The amount of output produced by a unit of

labour (Baumol and Blinder, 1999).

WHAT IS THE UNEMPLOYMENT RATE?

Defined: the number of people within the working population that is unemployed.

Formula: Unemployed X 100

Labour Force

e.g. 8 million X 100 = 5.3%

150 million

(source: Colander, 2006:525)

HOW IS UNEMPLOYMENT REPRESENTED IN ECONOMICS?

Generally, unemployment is represented using statistics that are presented using graphs, tables or other forms of appropriate representation that were generated by various agencies e.g. IMF, World Bank, ILO, Central Banks, other governmental agencies etc.

FIGURE: PPC ILLUSTRATING

UNEMPLOYMENT IN THE ECONOMY

A

Good Y Any point inside the PPC represents unemployment e.g. C. Once the PPC is not producing at a point along the curve AB and is producing at a point in side the curve means that there are unemployed resources that are available to increase the economy’s GDP.

 

KEYNESIAN CROSS: DEFLATIONARY GAP

GDP Capacity GDP

Deflationary Gap

Actual GDP

O Ye Y1 OUTPUT

CONCEPTUAL DIFFERENCES

How does the rate of unemployment differs from the participation rate?

The unemployment rate measures the percentage of the total workforce or labour force that is willing and able to work but cannot find jobs while, the participation rate examines the total labour force as a percentage of the total population.

 

TERMS RELATED TO INFLATION

1. Inflation – A persistent tendency for the general price level to rise (Hardwick et al, 1994).

2. Inflation Rate – The percentage increase in the retail price index over a period of one year.

3. Retail Price Index (RPI) – An index which aims to measure the change in the average price of a basket of goods and services that represents the consumption pattern of a typical household.

4. Consumer Price Index (CPI) – Is an index of inflation measuring prices of a fixed basket of consumer goods, weighted according to each component’s share of an average consumer’s expenditure (Colander, 2006: 531).

HOW IS INFLATION MEASURED?

Inflation is measured using an index i.e. RPI or the CPI.

Formula: Current Year – Base Year X 100

Base Year

E.g. 105 – 100 X 100 = 5%

100

N.B. the rate of inflation in this case is 5% and remember that the base year is always given an index of 100 .

REFERENCE

1. Baumol, William J, and alan S. Blinder. Economics: Principles and Policy. 8th Edition. USA: Dryden Press, 1999.

2. Colander, David C. Economics. 6th Edition. New York: McGraw – Hill/Irwin, 2006.

3. Grant, Stanlake. Introductory Economics.

7th Edition. Essex: Pearson Education Limited, 2000.

4. Hardwick, Philip, Bahadur Khan and John langmead. An Introduction to Modern Economics. Essex: Addison Wesley Longman Ltd, 1994.

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Summary 4 International Trade

Review of concepts:

(a) International trade vs Domestic trade

(b) Opportunity Cost

(c) Comparative Advantage vs Absolute Advantage

(d) Trade Barriers/Protection

(e) Economic Integration

What is International Trade?

1.International trade refers to trade between and among countries (or between and among distinct political entities).

2. This is different from domestic trading which occurs between and among traders of the same country.

Why International Trading?

‘International trade is vital to the health of any nation’, (Baumol and Blinder 1999, 729).

Based on one of the longest arguments for international trade, the argument of comparative advantage, international trade is said to give rise to higher standard of living among participating countries since it can lead to higher consumption levels (will refer later in the presentation).

Some other arguments for international trading

1. Differences in resource endowment – some countries may not have the factors of production necessary to produce certain goods, thus, will have to import such goods from another country capable of producing such goods.

2. Climatic differences – some goods can only be produced in tropical climates while others can only be produced in cold climates.

Some other arguments for international trading (Continues)

3. Differences in skills of labour – Some countries despite having the necessary natural resources are still unable to produce a particular commodity due to the lack of appropriate skills or ‘technical know how’.

4. Inability to mass produce – One of the arguments for economic integration is that of the need to overcome smallness in the size of domestic markets (review to forms of economic integration in appendix 1).

Some other arguments for international trading (Continues)

Absolute Advantage – a country has an absolute advantage in a commodity if it can produce that commodity more efficiently i.e. produce a larger quantity for a given level of inputs (Hardwick et al, 1994, 554).

Comparative Advantage – While a country has a comparative advantage in the production of a commodity should it produce that commodity at a relatively low production cost (lower opportunity cost) compared to another country (See Hardwick et al 1994, 554).

Economist’s Cost (Opportunity Cost reconsidered)

Opportunity Cost- defined as the value of the next best alternative forgone.

In the context of the economist’s cost, opportunity cost examines the alternative income that a factor of production would have generated/earned as a result of its current occupation/use. Example, if a sole trader in his previous employment was making EC $10, 000 per month, the opportunity cost of his current employment as a business man is therefore this EC $ 10, 000 per month, which must be accounted for as part of his cost of production.

In the context of the law of comparative advantage, the opportunity cost of producing a commodity is the amount (amount of resources) of another commodity that must be forgone (examined further in slides which follow).

Illustration of the Law/Theory of Comparative Advantage

Assumptions:

1. There is constant opportunity cost (the rate of change or the MRT is constant or the same at all points along the PPC).

2. There are two countries or economies.

3. Both economies or countries produce the same two goods.

4. Technology in both economies are said to be fixed.

Illustration Continues

Pre Trade Situation 2

Based on the assumptions that underline the theory of comparative advantage, an attempt at illustrating the latter would require producing two linear PPCs to illustrate the two economies with each producing the same two goods.

To establish whether the two economies should trade, we must first establish whether the two economies possess relatively lower cost of production in one of the two goods produced between them.

This is done by finding the production cost/opportunity cost of producing both goods for both economies.

Illustration Continues

Pre Trade Situation 3

Remember that the opportunity cost of producing a good is the amount of another good that must be forgone by reallocating resources. It is done by finding the slope (MRT) of the PPC between any two points of production.

In the case of the illustration of interest…..

Illustration Continues

Pre Trade Situation 4

Economy 1

1. In producing good X, the amount of good Y forgone (opportunity cost) is found by

y/x i.e. the amount of y to forgo to produce an additional unit of x is 100/100 =1

This 1 represents 1 unit of y forgone for every 1 unit of x produced.

2. In producing good Y, the amount of good X forgone (opportunity cost) is found by

x/y i.e. the amount of x to forgo to produce an additional unit of y is 100/100 =1

Again this 1 represents 1 unit of y forgone for every 1 unit of x produced.

Illustration Continues

Pre Trade Situation 5

Economy 2

1. In producing good X, the amount of good Y forgone (opportunity cost) is found by

y/x i.e. the amount of y to forgo to produce an additional unit of x is 200/100 =2

This 2 represents 2 unit of y forgone for every 1 unit of x produced.

2. In producing good Y, the amount of good X forgone (opportunity cost) is found by

x/y i.e. the amount of x to forgo to produce an additional unit of y is 100/200 =0.5

Again this 0.5 represents 0.5 unit of y forgone for every 1 unit of x produced.

Illustration Continues

Pre Trade Situation 6

Having found the opportunity cost of producing both goods for both economies it was clear that:

1. Economy 1 has a comparative advantage in producing good x relative to economy 2 as the opportunity cost of producing good x for economy 1 (which was 1) is less than the opportunity cost of producing x (which was 2) for economy 2.

Illustration Continues

Pre Trade Situation 6

While

2. Economy 2 has a comparative advantage in producing good y relative to economy 1 as the opportunity cost of producing good y for economy 2 (which was 0.5) is less than the opportunity cost of producing x (which was 1) for economy 1. N.B. also that economy 2 has absolute advantage in producing good y since it produces twice as much of this good than in economy 1 for a given amount of factor inputs.

Result, the two economies should specialize in the production of the good for which it has a relatively lower opportunity cost i.e. economy 1 should produce x only and economy 2 should produce y only and then trade the excess (see next slide).

Gains from trade 1

‘trade is a win-win situation as trade brings about mutual gains by redistributing products so that both parties end up holding preferred combinations of goods than they held before’ (Baumol and Blinder 1999, 732).

Based on specialization by both economies, the consumption possibilities of both economies can be expanded, thus giving rise to higher standard of living. (Graphically, through trade, based on comparative advantage, both economies should be able to consume at a point previously unattainable/scarce, such as point c in the diagrams that follow).

Gains from trade 2

PPC Economy 1 PPC Economy 2

Arguments for Protectionism 1

Despite the theoretical issues concerning trade, there have been attempts aimed at protecting domestic markets on the part of many governments (both developed and developing alike). Here are three frequently referred to arguments.

Arguments for Protectionism 2

1. Strategic Industry Argument – In the case where a particular industry is strategic for the government in terms of meeting macroeconomic objectives such as high employment, barriers to trade could be placed to avoid foreign competition.

Arguments for Protectionism 3

2. Infant Industry Argument – In the case where young and undeveloped industries are unable to compete with foreign firms, then barriers are placed to protect them.

Arguments for Protectionism 4

3. Protection against Dumping Argument-some governments are guarding against efforts by foreign firms to penetrate their domestic markets through efforts aimed at selling their goods in those markets below the price at which they are sold in the foreign firm’s domestic market.

N.B. the view is that such efforts will making foreign goods more competitive than domestic goods in such markets if allowed.

Forms of Protection 1

The forms of trade barriers which will seek to meet the objectives of reducing the presence of foreign goods in the domestic markets can be viewed in terms of tariffs and non tariffs of barriers, such as quotas, export restraint policy, export subsidy, foreign exchange control, public procurement policy, etc (some examined below).

Forms of Protection 2

1. Tariff – A tariff is a tax on imported items.

Impact: While a tariff can increase revenues to the government, as it impacts cost of operation of importers, it may also give rise to lower domestic demand for tariff imposed foreign items (this means that more efficient exporters will be more competitive).

Forms of Protection 3

2. Non Tariff Barriers – will have a similar effort as will tariffs.

A non tariff barrier such as quotas will imposed a direct maximum on the quantity, value or percentage of the domestic market so as to protect a significant portion of the domestic market for domestic markets (review other non tariff barriers in your notes and text).

Negative Effects of Protection

Despite the potential curtailment of foreign produced goods and increase in revenues (in the case of a tariff), there are potential disadvantages of such protectionist policies such as;

1. Potential trade war (beggar my neighbour policy).

2. Promoting inefficient firms/industries.

3. Higher welfare implications in terms of higher consumer prices and thus a lost in consumer surplus.

Appendix 1: Economic Integration

Type of Economic Integration

Characteristics Examples

Free Trade Area (FTA) Removal of barriers to trade among participating countries

NAFTA (1990s)

Customs Union A FTA plus the imposition of

the Common External Tariffs

(CET)

Caricom in the 1980s

Common Market/Single Market

Complete removal of barriers on the movement of all productive resources plus other common economic arrangements.

CSME

Economic Union Single Market plus

Monetary Union

European Union

Appendix 2

References:

1. Baumol, William J, and alan S. Blinder. Economics: Principles and Policy. 8th Edition. USA: Dryden Press, 1999.

2. Colander, David C. Economics. 6th Edition. New York: McGraw – Hill/Irwin, 2006.

3. Hardwick, Philip, Bahadur Khan and John langmead. An Introduction to Modern Economics. Essex: Addison Wesley Longman Ltd, 1994.

4. Sloman, John. Economics. 5th Edition. Essex: Pearson Education Ltd, 2003

Summary 4 international trade.

Areas of interest

1.what is absolute advantage 2. what is comparative advantage 3. the difference between absolute advantage and comparative advantage i.e. AA focuses on the economy which produces more units of a good relative to another while CA examines the relative cost of producing the commodity in terms of opportunity cost 4. You need to be able to illustrate absolute advantage and comparative advantage 5. why do countries engage in international trade; differences in resources, climate, differences in skills, comparative advantage, 6. benefits/arguments for free trade/aganist trade protection; prevent trade war, discourage inefficiency and encourages more competition, more choices for consumers, increase consumer welfare 7. cost of international trade/arguments for protectionism; avoid dumping, protect strategic industries, protect infant/sunrise industries, raises revenue for government etc. 8. When countries engage in international trade the many transactions are recorded in an account called the balance of payments – it is made up of the current account (which has four sections) and the capital and financial accounts. 9. Another sub topic examined was terms of trade –  what is it i.e. relative price of exports vs relative price of imports – when the price of exports increased relative to the price of imports the terms of trade improves and when the price of exports decreases relative to the price of imports the terms of trade worsens. The extent to which a change in the terms of trade will negatively affect the BOP or cause current account deficits will depend on the level of price elasticity of demand for exports and imports – If the terms of trade worsens then it means that the price of exports decreased relative to the price of imports, this situation may not affect the BOP negatively if PED is elastic while if PED is inelastic then a worsen of the terms of trade will worsen the balance of payment (current account deficit).

Summary macroeconomic issues

This summary note addresses three topics; inflation, balance of payment and exchange rate. These represent three major macroeconomic issues. Other macroeconomic issues include unemployment, growth and development.

(a)    Inflation

Inflation is the persistent rise in the average price level. What you need to know.

1.      Causes of inflation; demand pull (cause by too much spending in the economy especially when consumers have excess cash to spend in the economy/economy is doing well/booming), cost push inflation (rising cost of production due to wage hikes, oil price hikes etc) and extensive increases in the money supply (remember Germany in the 1920s). (Remember how to draw the diagrams to illustrate inflation).

2.      Consequences of Inflation – inflation could have many harmful effects with some positive effects.

causes poverty as cost of living increases – so the low income groups are worse affected, loss of confidence in the local currency which could lead to a run on the banks as people try to withdraw their entire life savings, savers are affected, less investment as banks are less able to give loans when people are saving/depositing little, pensioners with fixed income are affected, lenders are affected while borrowers gain, shoe leather effects as consumers search for better deals, menu effects as firms have to constantly change their price tags.

(b)   Balance of Payment

Balance of payment focuses on current accounts problems. Make sure you know that.

1.      What causes BOP disequilibrium/current account deficit; limited exports (lack of economic diversification), too much importing etc. 2. What can be done to address BOP disequilibrium (current account deficit)? i.e. economic diversification, trade barriers e.g. tariffs, subsidy and quotas, demand management policies (see mark scheme for ER for distinction between expenditure switching and expenditure dampening). N.B. These policies are not always effective.

(c)    Exchange rate – 1. types of exchange rate; fixed, flexible/floating and managed float (managed float is not the same as flexible/floating exchange rate); 2. How are they determined and illustrate these (using graphs) N.B. Fixed, determined by central bank/government and with this system government engages in constant open market operations i.e. buying the currency using foreign currency when the demand for the currency is low and it is losing value and selling the currency to purchase foreign currency when the currency is increasing in value. Flexible determine by market forces and explain what these are (diagrams). Manage float adopts elements of both (see your notes for diagram. 3. What is meant by devaluation/depreciation? 4. What is meant by revaluation/appreciation? 5. What are the advantages and disadvantages of both extreme types of exchange rate regimes?